“We believe that the probability of default is approaching 100 percent, and that losses given default are substantial,” Moody’s wrote on Wednesday about Puerto Rico’s $72 billion in bonds that were stuffed into numerous conservative-sounding bond funds spread across America’s retirement portfolios.

“Bondholder recoveries will be lowest on securities lacking explicit contractual or other legal protections,” the report went on, according to Bloomberg. About $26 billion in bonds fall into this category, issued by entities such as the Government Development Bank, Highways and Transportation Authority, Infrastructure Finance Authority, and Municipal Finance Authority. Investors in these bonds might recover only 35 cents on the dollar.

Recovery rates for bonds with stronger investor protections, such as general obligation bonds, would likely range from 65% to 80%, Moody’s said.

But those recovery rates, as dire as they seem, only apply if you own the bonds outright. If you own those bonds in a bond fund, the scenario may look much, much worse, according to what UBS just did.

Turns out, some of these bonds were underwritten by UBS and stuffed with other Puerto Rico bonds into its own Puerto Rico closed-end bond funds and sold to its own unsuspecting clients. These funds aren’t traded; UBS sets the value.

And UBS, despite the well-known problems Puerto Rico has been having for years, wasn’t shy about loading up its clients up with these bonds, apparently, according to Reuters:

Many UBS brokers had misgivings about the funds even as UBS’ Puerto Rico chairman was pushing them to sell the bonds, according to a voice recording, reported by Reuters in February.

And then there was leverage, as recommended by UBS brokers because UBS profits even more, not only in selling the bond funds but also in lending the money:

Many of those investors bought even more fund shares with money they borrowed through credit lines from another UBS unit, after several UBS brokers may have improperly advised them to do so, according to a $5.2 million settlement between UBS and Puerto Rico’s financial regulator in 2014.

Since the collapse of Puerto Rico bonds, the funds have become “legal headaches for the firm,” as Reuters put it, with the FBI “investigating allegations about UBS’ sales practices that touted the funds’ high yields and tax advantages.”

OK, looks like these funds have become a sordid business. But as unlikely as it may seem, they just now got even more sordid:

UBS sent out a letter to its clients on July 13, and at least one of those incensed recipients must have leaked a copy to Reuters. In this letter, UBS said that it “will also reduce to zero the collateral value assigned to all Puerto Rico closed-end funds shares.”

To zero!

Clients were warned that they can no longer use these funds as collateral for loans, even those loans they used to buy these funds with in the first place.

That’s how risky UBS thinks these bond funds are. But UBS sets the value of these funds, and for now, they still have “value,” at least on its website, according to Reuters: “For example, one of the riskiest funds was worth $3.46 per share as of Thursday….”

By having the collateral value of their bond funds cut to zero, these clients are looking at a potentially grim situation:

Jeffrey Sonn, a lawyer in Florida, who represents some of the investors, told Reuters that UBS might liquidate the assets of clients who used these Puerto Rico bond funds as collateral for loans and might even take legal actions against them if they fail to produce additional collateral to replace the funds.

This would nicely top off the sordidness of all this, given how much money these clients have already lost on these bond funds. Consequences?

Lisa Bragança, a lawyer for Stoltmann Law Offices in Chicago which represents some of the investors, said the admission that the collateral value of these funds is now zero could bring on more investor arbitration claims against UBS, on top of the hundreds that have already been filed.

“This is a real pickle for UBS to say the collateral value assigned to the closed-end fund shares is zero,” Bragança said.

By doing so, UBS is effectively admitting that it sold a bad product and that the funds are too risky for the firm itself, let alone average investors, lawyers said.

So the lawyers are going to get rich. UBS clients might eventually recover a small portion of their original investment and weep over the rest. And UBS will simply brush off the outcome as another “charge from legal settlements,” or something similar, one more in many, and exclude it from its adjusted, pro-forma, non-GAAP, ex-items EPS number, which is all that matters to the hype mongers that analysts have become. And life goes on.

Just the beginning of Great Bond Unravel where the collaterals are not there, depreciated. worthless or been pledged multiple times. And it might trigger the mother of all domino effect liquidations on this highly leveraged markets once the client’s collateral are re-valued as the markets heads south triggering more margin calls thanks to shrinking/evaporating assets.

NY Geezer

Jul 24, 2015 at 10:05 am

Government bond default is supposedly unthinkable because we all know that there is no expectation that this debt will ever be repaid.

The debt only has legitimacy because lenders expect that interest payments will always be made so that the bonds are never in default. The EU is contorting itself to avoid default in Greek bonds.

That the economic superpower, the US, will just allow Puerto Rico to default is shocking to the entire sovereign bond regime.

Tom Nacey

Jul 27, 2015 at 9:19 am

Or, alternately, the bonds will sell at an 80% markdown to a large politically connected financial entity. After which, the FED will announce a bail out at full face value with magically created money. 80% loss for some, and a 500% profit for someone else. Any bets?

Eugene J Du Bielak

Jul 27, 2015 at 4:34 pm

The Federal Government ostensibly not bailing out Puerto Rico is the first sensible action taken regarding this sun baked rock. Why should US Taxpayers pick up the tab for a wasteful and corrupt government? It is time Puerto Rico faced reality instead of living in the fantasy any further. Puerto Rico needs to become independent and accept the discipline that is part of good government.

robert h siddell jr

Jul 24, 2015 at 10:45 am

Divide $72 billion by 320 million Americans and the loss is only $225 per man woman and child. I’m sure the rest of the bond market is OK though and we can ignore this little problem.

robt

Jul 24, 2015 at 12:10 pm

Divide it by the number of Americans that actually work and it’s well over a thousand each … but the real point is that PR is a territory of the US, and if daddy doesn’t even want to bail it out for small change, like just paying the interest and putting it on the tab, that’s a bad signal. What about many of the other territories, otherwise known as States?

Petunia

Jul 24, 2015 at 12:55 pm

All those Puerto Ricans are US citizens. BTW, those “defaulted bonds” are not GO, general obligation bonds, they are defined to be payable by budgeted funds. They simply did not allocated the funds because they didn’t have the money. The investors knew that they ran the risk of not getting payments allocated. Technically they are not even defaulted.

VegasBob

Jul 24, 2015 at 2:41 pm

The bonds that have a payment date of August 1 are the ones that are going to default due to non-appropriation of funds to pay the interest. I haven’t looked at a prospectus to see if any of those August 1 bonds have grace periods (often 30 days) to make a missed payment.

What’s important to consider is that the August 1 bonds are only a small portion of Puerto Rico bonds. The overwhelming majority of Puerto Rico bonds have payment dates of January 1 and July 1.

So an August 1 default will be relatively minor compared to a January 1 default.

Even though Puerto Rico is basically a self-governed US territory, if Puerto Rico defaults on January 1, I think everybody should consider whether or not the sovereign debt of the US is “money good” – i.e., principal and interest will be paid on time.

In the long run, a parent that is not willing to step up to the plate and accept responsibility for its children will fail to live up to its own responsibilities at some point as well.

Vespa P200E

Jul 24, 2015 at 12:43 pm

No divide that $72 bil by 3.7 mil people living in PR and it comes out to $19.5k per person there living in PR as why should US citizen bailout PR?

Then what about thousands of local, county and state debts? Who is going to bail them out when you add $16.3 trillion and growing Fed debts?

Debt is either paid off or defaulted, even much later

Jerry Bear

Jul 25, 2015 at 4:23 am

i am beginning to wonder just to whom all this debt is actually owed? I have never gotten a straight answer on that.

Nigelk

Jul 25, 2015 at 9:57 pm

Ask the Creature from Jeckyll Island

Nick Kelly

Jul 31, 2015 at 12:32 am

Surely you are being sarcastic

hoop

Jul 24, 2015 at 11:17 am

This article reminds of the collapse in the summer of 2007 of 2 hedge funds of Bear Sterns. The reply from NY Geezer reminds me of Lehman. So does it take another year and a half or are we going down from here fast.

hal

Jul 24, 2015 at 12:04 pm

remember the President said no major loss here due to Greece and Puerto Rico–I guess it depends if you are in the losing class or not.

Bob Miller

Jul 24, 2015 at 1:12 pm

I’m in a good mood today. I was able to cover two of my shorts. Did I make any money? Are you kidding, I’ve been paying dividends now for three years on these stocks. But when, and if I get all my 200K back, I’ll feel like I made a million.

Hard to believe that people would buy into Puerto Rican bonds. I’ve been reading for a couple years that Puerto Rico would probably have to default on them. Amazing.

Jerry Bear

Jul 25, 2015 at 4:27 am

I am getting the disturbing impression that a lot of the investors dont bother to read the news. If you are going to invest some serious bread you had better remember the old adage of “Let the buyer beware”!

Nycjeff

Jul 26, 2015 at 10:09 am

with the rule of law eroding rapidly, investors should probably assume a seller is actively trying to rip them off, assuming there will be no repercussions. buyer beware to the Nth.

Bob Moreno

Jul 25, 2015 at 4:56 pm

The real problem behind this big default are the well spoken and dressed charlatans ,who compose the main two political parties in the island of Puerto Rico, the Popular and Nuevo Progresista parties. Fortunately, The Krueger Report showed that these guys did not know what the heck they’ve been doing for the past 65 years. By the way this is not news, it just finally came out to public knowledge now.
Then you throw in the deformation in the bond market created by the bozos in the Eccles bldg. by keeping interest rates pegged at zero for six yrs! , the irrational greed for yield it has produced among bond funds and investors, and you can understand how bad this situation was going to end. There are some PR’s sociopolitical factors, or idiosyncrasies if you will, which are being left out in assessing the probabilities of payments ever being made. By the way , if investors get 5 cents on the dollar on the GO bonds, they should consider themselves lucky. In my opinion, that’s how dire the situation is.

John Galt III

Jul 27, 2015 at 8:10 am

25% of the workforce is ’employed’ as government ‘workers’. They get paid way more than the private sector and have cushy pensions. No one ever fires them.This place is no different than a California bankrupt municipality or Chicago.

They chose years ago to keep Spanish as their official language which hasn’t helped much either. The US has plenty of Spanish speakers and the Puerto Ricans keep leaving PR and moving top the mainland where Spanish isn’t as useful.

Then, Congress keeps changing the rules on them. John Paulson keeps buying property there and rich hedge fund managers like the place for the newish legislation that allows them to pay no US income taxes if they live there a little over half the year.

The place may work out but needs to 1) Pare back and control government employment,(2) get rid of the Jones Act, (3) write a lot od the debt and about (5) other sensible reforms and the place could do well.

clay von hake

Jul 27, 2015 at 11:50 am

Get rid of the Jones Act? Are you nuts? Rely on foreigners for our domestic coastwise commerce? Maybe turn over your dept of energy to Gazprom while your at it.

Nick Kelly

Jul 31, 2015 at 12:36 am

Obviously he means except PR from the Jones Act.

Melvin Taggart

Jul 27, 2015 at 2:50 pm

IMO; They should have Public Laws that eliminate the courts being used for collection of the debts that are insured by hedges. China has such a Code.

When hey start up again, if they do, there could be different ownership of large portions of the PR.
Maybe they might be bright enough to use for a draft; the Glass-Segal Act [B. Clinton rung congress’s arms to get it stricken from the U.S. Code so Hedge brokers and banks could insure their questionable loans with Federal Backing. They seem to be exempt from prosecution also. (Ref Henry Paulson)] Due your own due diligence.

gwb

Jul 28, 2015 at 1:04 pm

Several months ago, somebody from UBS cold-called us at home, trying to drum up “wealth management” business. Judging from the PR bond fiasco, sounds to me more like an asset-stripping business…

Rocky B

Jul 29, 2015 at 7:39 am

GWB: Old people with money should get themselves Caller ID phones, monitor their calls and not talk to strangers. If in doubt, let the call go into voice mail or your answering machine.

Rocky

Jul 29, 2015 at 7:42 am

MBIA and its various bond insurance affiliates are probably going down for the count, barring a last minute miracle.

Joe

Jul 31, 2015 at 5:20 pm

Sorry, these aren’t treasuries, and allowing a territory, state, or city is NOT the same as the U.S. Treasury defaulting on its debt. People bought these bonds due to their high yield despite their high risk, and now it’s time to pay the piper.

I’d feel exactly the same if Chicago or Detroit were allowed to go bankrupt and default on their bonds. Socialist hellholes where crooks run the place quite often result in poor economic performance. This shouldn’t surprise anyone, so put in some due diligence before buying the debt of any city, state, or territory.
(Hint – the higher the yield, the higher the risk!) You’re welcome!